The Issue of Unemployment and Inflation in Colombia

In 1991 the Colombian authorities implemented inflation target for the first time, at the time the central bank (Banco de la Republican, BR) and the government were not clear about their tasks on macroeconomic management and there was not an authority that set any monetary policies. Therefore, the nature of inflation targeting and operational meaning was perplexing and was met with low credibility (Gómez, Uribe and Vargas, 2002). Unemployment in Colombia has one of the highest rates compared with the world and Latin American average. Even though the levels of unemployment in Colombia have been decreasing in the examined period (1991 to 2015), there have been periods of high unemployment such as 1999 and 2000 with 20.1% and 20.5% of people unemployed. There has been a debate about whether there is a relationship between unemployment and inflation and if there is a trade-off between these two. Economist A W Phillips created the famous “Phillips curve” that describes the inverse relationship between unemployment and inflation. However, economist such as Friedman and Phelps believed that in the long run, the relation between unemployment and inflation was non-existent (Razin and Yuen, 2002). This paper attempts to estimate the relationship between inflation and unemployment in Colombia between 1991 to 2015 and in the short term; the year 2015. Finally, this paper looks at targeted inflation in Colombia since it was introduced in 1991 and how successful it has been in the reduction of inflation as far as 2015.

The following section will review the relevant literature on the relationship between inflation and unemployment. In order to understand the relation between this two variables, inflation, targeted inflation, the Philips curve, and unemployment will be discussed.

In simple terms, inflation is the rise in the levels of prices in the economy. Firms react to the levels of prices of the economy. Thus, if there is a substantial change in aggregate demand, firms will respond to the changes. If aggregate demand rises, firms will likely raise their prices and if demand is high they will push prices up in order to raise their profits (Sloman, ). Inflation is measured by the increased in price levels therefore by price indexes. There are three main inflation indices: Consumer price index (CPI) and GDP deflator, and Producer price index (PPI) (Hubbard and O'Brien, 2007).

CPI: is the main measure of levels of inflation. It takes the consumer basket and services that are used by households such as water and food and measures the changes in its price levels. The prices on this index are weighted on a periodical basis in quantities (Mankiw, 2007). In 2017, in the UK the national office of statistic introduced a new measure called consumer price inflation including owner-occupiers’ housing cost (CPIH) which acts as CPI but it is adjusted for average residential rents (the Chu, 2017).

PPI: Similar to CPI, PPI takes the consumer basket and services to measures the changes in its price levels but instead of households, PPI takes the prices of goods and services of the production of firms such as raw cotton and petroleum (Hubbard and O'Brien, 2007).

GDP deflator: It measures every final good and services produced in a country during a period of time, usually a year using the ratio of nominal and real GDP (Hubbard and O'Brien, 2007).

From 1991 Colombia began targeting inflation and between the years 1992 and 1999 monetary policy was introduced. However, the first inflation targets that were set were more in the form of a forecast than an objective of monetary policy (Gómez, Uribe and Vargas, 2002). According to the law, the central bank (BR) must announce an inflation target lower than the observed inflation rate of the previous year. The legal framework used for price stability was introduced in the 1991 constitution and the central bank must comply with the regulation to achieve price stability in Colombia (Gómez, Uribe and Vargas, 2002).

The unemployment or employment rate is measured by the labor force. The percentage of the labor force that is unemployed is defined as the unemployment rate. There are three main types of unemployment. Frictional, structural and cyclical (Hubbard and O'Brien, 2007).

Frictional unemployment: it refers to the time an unemployed person spends to find a job. This unemployment is often short term as it is the process that it takes for a worker to find a job.

Structural unemployment: it refers to the mismatch between the skills and abilities needed for the job and the person looking for a job. This unemployment is often long-term because new skills need to be learned and people need to be re-trained.

Cyclical unemployment: this type of unemployment happens due to economic recessions. As an economy enters recession firms need to cut down production and need to fire workers as they cannot afford them.

There have been several research on the relation between inflation and unemployment. In 1958, the economist A.W Phillips was the pioneer in the research of the relation between these two macroeconomic variables. The Philips curve suggests that there is an inverse relationship between inflation and unemployment. Phillips demonstrated the supposed relationship with his research in the UK and observed that as aggregate demand rose, the levels of inflation increased but unemployment decreased and that wages increased rapidly in periods of low levels unemployment whereas wages increased slowly when there were periods of high levels of unemployment (Singh and Verma, 2016).

The curve has been a benchmark for policymakers. Either they can lower the levels of unemployment but at the cost of higher inflation or decrease the levels of inflation at the cost of high levels of unemployment. However, further research from 1960 suggests that the trade-off between unemployment and inflation is limited (Sloman and Garratt, 2010).

Therefore, the Phillips curve works under three assumptions:

1. In the short run, there is a tradeoff between inflation and unemployment
2. In the short run, stagflation can break the tradeoff between inflation and unemployment
3. There is no tradeoff between inflation and employment in the long run.

Since then, many economists have studied this relationship and its accuracy. Research conducted by Mankiw (2001) suggest that monetary policy is highly important as it influences unemployment and in its turn it influences inflation, hence, there is a trade-off. Mankiw believes that the Phillips curve is a good standpoint, however, it fails to describe the dynamic of the relationship between unemployment and inflation as the Phillips curve does not take into account any price adjustment theories. Alisa (2015) concluded that the Phillips curve gives important Insights to policymakers. However, it means that policymakers need to choose between higher unemployment or higher inflation as the Phillips curve suggest that in the short term price stability and full employment is unattainable. Also, his research on the Russian Federation agrees with Friedman that the Phillips curve is an only a short-term effect.

Furthermore, the work of Slezarov (2012) shows that there is a strong relationship between unemployment and inflation in the Czech Republic, however, that is not the case of Slovakia as her studies showed that the relationship is very weak as the linear regression revealed a positive slope. Further studies concluded that inflation expectations and uncertainty of inflation levels play a central role in the Phillips curve (Fuhrer, 2009). The case of the of the Federal Reserve is a good example of the significance of inflation expectation and why relying too much on the Phillips curve can also be a problem. In the 1970s, members of the Federal Reserve believed they could push down unemployment without the risk of raising the levels of inflation. They created policies that reduced unemployment but did not take into account that people expectations about inflation kept changing as a consequence the levels of inflation rise more rapidly (Bunker, 2015).

However, there is a debate as to the validity of the Philips curve. In 2015, the world economic Forum released an article raising the question if there needs to be an update on the Phillips Curve, due to recent events that have led to believe that there is not a strong relationship between inflation and unemployment rates. Therefore, policymakers are having trouble determining their next policies that will lead to low unemployment rates and low inflation. Moreover, the Peterson Institute conference had a debate about whether the relationship between inflation and unemployment is still relevant and if not what does it mean for policymakers. Although many economists believe the Phillips curve is still relevant they also believe it needs to be rethink (Davis, 2017).

Furthermore, this is not the first time there has been a debate on the Philips curve theory. In 1976, the studies of Milton Friedman showed that the trade-off between unemployment and inflation is an only short term and it will dissolve in the long run for two reasons. First, because he believed that increased nominal demand will lead to lower unemployment and thus an increase in wages. Therefore, firms expected higher output because of the expansion and would be willing to pay more to its workers. The rise in nominal wages would be perceived as to be rising faster than real prices. As a result, the supply of labor would rise and workers would eventually realize that the real wages did not increase which will lead to the adjustment of the economy. Second, because he believed that the slope of the curve could be positive as higher inflation can be associated with high levels of unemployment as economies in the 1970s were experiencing (Friedman, 1978). Today, most economists believe that there is no long-term trade-off between unemployment and inflation.